Sunday, December 31, 2017

One year ago I expected to see an improving economy and further gains in equity prices, and I sure got that right. Stocks are up big-time and GDP growth has accelerated somewhat. But I worried, as I have every year for the past 8 years, that the Fed might be slow to react to rising confidence and declining money demand, and that this could set off a bout of rising inflation. Fortunately, I got that wrong yet again, since inflation has remained in a comfortable 1.5 - 2% range. For the past two years I've liked emerging markets, and they have done quite well. Last year I didn't much care for gold or commodities, but they have done well thanks to a weaker dollar—which I didn't see coming. So it's a mixed bag for calls, but last year's 19.4% rise in equity prices goes a long way to making up for a few smaller losses. In any event, take the following with suitable grains of salt. I've been bullish and right (on stocks) for so long now that it makes even me nervous.

All throughout 2017 the world worried that Trump and the Republicans were going to prove incompetent. Was Trump crazy? Could he actually govern? Could the Republicans abolish Obamacare as promised? Could they pass tax reform? Turns out they did a pretty good, if far from perfect, job. Obamacare is being dismantled, beginning with the elimination of the mandate. Tax reform could have been better, but it achieved its main objective: to stimulate investment. Meanwhile, hidden behind the distractions of tweet storms and faux pas, Trump has accomplished a major reduction in federal regulatory burdens. This can really make a difference over the long haul, and it may already be contributing to faster growth.

Thinking back, Obama in his first year got a $1 trillion dollar stimulus package designed to boot-strap the economy by redistributing income (see my analysis here). The result was the slowest recovery on record; Obama ended up borrowing some $8 trillion to no avail, since nothing he did was aimed at increasing the market's desire to invest, work harder, or take risk. Trump in his first year got a $1.5 trillion (CBO-scored "cost") stimulus package designed to boost the economy by increasing the after-tax returns to business investment. I'm betting the results of Trump's tax reform will be much better than expected, but the market is not yet willing to make that same bet, and that is the point of departure for all predictions of what is to come.

If 2017 was about just one thing, it was the ability of the Republicans to pass meaningful tax reform. The market spent most of the year handicapping the odds of tax reform, and it would appear that it is now mostly, if not fully, priced in. The tax reform package boils down to a one-time 20% boost to after-tax corporate profits (by cutting the corporate income tax rate from 35% to 21%), and that's pretty much what we have seen happen to equity prices this past year.

If 2018 is going to be about just one thing, it will be whether boosting the after-tax rewards to business investment results in a stronger economy. Beginning in 2009, Obama and the Democrats gambled that a massive redistribution of income would boost demand and thus boost the economy, but they lost. They ended up flushing $8 trillion down the Keynesian toilet. Trump and the Republicans are now gambling that a significant increase in the after-tax rewards to business investment will boost the economy. Only time will tell, but there are already hints of a stronger economy in the data: e.g., capex is up, industrial production is up, business confidence and the ISM indices are up, and industrial metals prices are up. It's likely that the current quarter could mark the first time we've enjoyed three consecutive quarters of 3% or more growth in over 12 years.

I think the meme for 2018 will be this: waiting for GDP. If the economy shows convincing and durable signs of stronger growth, more investment, more jobs, and rising productivity, then the Republicans' gamble will have paid off. If not, the Democrats will have carte blanche to take control of Congress and oust a sitting president.

From my supply-sider's perspective, we now have the essential ingredients for a stronger economy in place. Tax incentives are correctly aligned to encourage more business investment; regulatory burdens are being slashed, business confidence is high, and the Fed is not a threat for the foreseeable future. Swap and credit spreads are low, as is implied volatility, and that tells us that liquidity is plentiful and systemic risk is low. The fact that the rest of the world is also doing better as well is just icing on the cake.

But, argue the skeptics, won't businesses just use their extra profits to buy back shares and increase their dividends, making the wealthy even wealthier without creating any new jobs? This oft-repeated allegation is an empty argument, because it ignores one key thing: what do those who receive the money from buybacks and dividends do with it? John Cochrane explains it in this brief excerpt (do read the whole thing):

Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.

The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.

In other words, what some companies do with their extra cash is immaterial. What matters is that tax reform has increased the marginal incentive to invest—for the entire economy—by reducing tax rates and by allowing the immediate expensing of capex. On the margin, investment now has become more attractive and more profitable in the US, and this will almost certainly result in more investment (some of which is likely to come from overseas firms deciding to relocate here), which in turn means more jobs, more productivity, and higher real incomes. As I explained a few years ago, productivity has been the missing ingredient in the current lackluster recovery, and very weak business investment is one reason that productivity has gone missing. A pickup in investment is bound to raise productivity, which is the ultimate driver of growth and prosperity.

So it's clear to me that tax reform is a big deal, because it's very likely to boost the long-term growth trajectory of the US economy by a meaningful amount. Surprisingly, however, the market does not appear to share that view. Why else would real yields still be miserably low (e.g., 0.3% for 5-yr TIPS)? Why else would the market expect only a modest increase (0.75% or so) in the Fed's target funds rate for the foreseeable future? The current Fed target is 1.5%, while 2-yr Treasury yields, which are the market's expectation for what that rate will average over the next two years, are only 1.9%. As for real yields, the current Fed target translates into a real yield—using the PCE Core deflator—of roughly zero, while the yield on 5-yr TIPS says the market expects that rate to average only 0.3% over the next 5 years. If the economy really gets up a head of steam (e.g., real growth of 3% or more per year), I can't imagine the Fed wouldn't raise rates by more than the market currently expects, and I can't imagine nominal and real yields in general won't be significantly higher than they are today. The last time the economy was growing at 4% a year (early 2000s), 5-yr TIPS real yields were 3-4%.

Yet the Fed is the one thing I worry about, which is nothing new. The Fed has been responsible for every recession in recent memory, because each time they have tightened monetary policy in order to reduce inflation or to ward off an expected increase in inflation, they have ended up choking off growth. They are well aware of this, however, so they are going to be very careful about raising rates as the economy picks up steam. But as I've explained many times before, the Fed's worst nightmare is a return of confidence. More confidence in a time of surprisingly strong growth would almost certainly reduce the demand for money; if the Fed doesn't take offsetting moves to increase the demand for all those excess reserves in the banking system (e.g., by raising the funds rate target and draining bank reserves) the result would be an unwelcome rise in inflation. Inflation is a monetary phenomenon: when the supply of money exceeds the demand for it, inflation is the inevitable result. And higher inflation would set us up for the next recession.

On balance, I think it's quite likely the economy is going to improve, and surprisingly so. Ordinarily that would be great news for the equity market, since a stronger than expected economy should result in stronger than expected profits. But the market is still cautious, so good news is going to be met with increased skepticism: if the Fed raises rates as the economy improves, the market will worry that higher rates will increase the risk of recession. And even if the Fed is slow to raise rates, the market will see that as a sign that inflation is likely to move higher, and that would in turn increase the odds of more aggressive Fed tightening and eventually another recession. In short, we're probably going to see the market climb periodic walls of worry, just as it has for the past several years.

Risk assets should do well in this environment, given time, but there will be headwinds. Rising Treasury yields will act to keep PE ratios from rising further, so equity market gains are likely to be driven mainly by stronger-than-expected earnings. At the same time, higher bond yields will make it easier to people to exit stocks (very low yields today make being short stocks very painful).

Emerging market economies are so far behind their developed counterparts that they have tremendous upside potential in a world that is increasingly prosperous, but a stronger than expected US economy is likely to boost the dollar, which in turn would put pressure on commodity markets and the emerging economies that depend on them.

I continue to believe that gold is trading at a significant premium to its long-term, inflation-adjusted price (which I estimate to be around $600/oz.) because the world is still risk-averse. So a stronger US economy and a stronger dollar would spell bad news for gold. Who needs gold if real yields and real growth are rising?

In order to judge whether things are playing out in a healthy fashion, it will be critical to periodically assess the status of the world's demand for money—particularly bank reserves, of which there are over $2 trillion in excess of what is needed for banks to collateralize their deposits. If banks' demand to hold excess reserves declines faster than the Fed's willingness to drain reserves and/or raise the interest rate it pays on reserves, then higher inflation is almost sure to rear its ugly head. Signs of that happening would likely be seen in rising inflation expectations, a falling dollar, a steeper yield curve, and/or rising gold and commodity prices.

The world is on the cusp of a new chapter of stronger growth, led by US tax reform. The US economy has plenty of upside potential, given the past 8 years of sub-par growth and a significant decline in the labor force participation rate and lingering risk aversion. Tax reform can and should unleash that underutilized potential and boost confidence. The future looks bright, but there are, of course, lots of things that could go wrong (e.g., North Korea, the Middle East, Trump's ego, the Fed) so if and as the world becomes less risk averse, an investor would be wise to remain cautious, since very few things these days are obviously cheap. On the other hand, Treasuries, and bond yields in general, look very low and should thus be approached with great caution.

21 comments:

I think the marginal incentives are the real jewel in all of this. Not only the reduction in corporate tax, but the regulatory cuts making a more friendly environment for businesses and workers. Just finished an article on the amazing reduction in federal regulations that have cut the register from 90K+ pages per annum under Obama to just over 50K this last year, and many of those were devoted to undoing prior regs. Having a more stable judiciary should help as well. Great post Scott!

Another extremely solid annual look-ahead by Scott Grannis and little with which to take issue.

As for federal spending, remember the US will spend $24 trillion or more through the Bush, Obama and Trump administrations on national security (VA, DoD, black budget, DHS and pro-rated interest on debt payments). This is part of the Keynesian stimulus too. It appears likely that your grandfather, your father, you and your sons and your grandsons and great grandsons will pay about 5%-6% of lifetime income (perhaps more if they are financially successful, perhaps less if they are less successful) into the national security bin. My own take is social welfare spending does not work, and national security outlays often appear counterproductive.

My own guess is interest rates do not budge much in 2018. There appears to oceans of global capital, and we have globalized capital markets. Cap rates on grade A commercial real estate (a rival for some types of savings) are low.

Just where the heck should you dump your money?

Some argue there is effectively forced saving in China, and much of prospering Far East appears to have a propensity to save. World incomes are rising, so the fraction of the population that can squirrel away savings is rising. Add on, there are sovereign wealth funds (more non-market savings), and in many types of business insurance is a requirement, and Insurers pool capital, which is a type of savings. Sadly, there appears to be kleptocracies in many nations that add to the global savings pool. Finally, offshore bank accounts are bulging with $32 trillion, and perhaps more. The ability to avoid taxes or plunder nations has arguably boosted global savings.

So tally supply and demand on interest rates, and the supply is ample. My further guess is that any slowdown in the global economy would see rates fall to zero and quickly, especially for government bonds.

The risk is just that: A recession happens in 2018 for some reason we do not see, and the world's central banks are unwilling to go to helicopter drops, and barely willing to go back to QE. Interest rates go to zero.

The liquidationist argument is that many businesses in a recession should go under, and a lot of capital should evaporate, to bring back balance between supply and demand for labor, enterprise and capital. Of course as businesses are going under, the demand for capital is falling in a recession. As my late Uncle Jerry used to say, "It is a rocky road to rock bottom."

Savers are entitled to a gain, and also a loss on their savings, as determined by Mr. Market. And right now, Mr. Market sees a lot of savings looking for a home. If there are $9 of worthy investments in the world and $10 in savings....

But 2018 looks good. If you get a whiff of recession, you may wish to crowd into cash or government bonds. Which may offer the same yield anyway.

Scott….Thank YOU….for all the excellent comments from 2017 and THANKS for the excellent kick off and summary that you provided going into 2018. I wish YOU and YOUR FAMILY the best for 2018. Take care. Kenn Hugos Phoenix AZ

Super work Scott. You are THE best. Optimists beat pessimists 90% of the time. I know we don't agree but I maintain the asset prices can be more determined by supply/demand than basic economic forces such as "expected" inflation. Bonds are THE classic example. They SHOULD be falling but they're not!'18 will be very interesting. Wouldn't want to be a whacko left winger. People vote their pocket book and I believe forces are in place for a solid growth number.

Thanks Scott, your insights are always appreciated. I have not commented on your posts in the past as my expertise lies elsewhere. But I do know enough to recognize your generosity of spirit and your clear headed brilliant analysis. Along with many many others I take the Grannis macroeconomics course every week or so and benefit with a deeper understanding of these complex systems. Again thank you and best wishes to you and your family for 2018.

I appreciate all the thanks. It’s nice to be appreciated, since that is my only recompense for doing this blog. Actually, one of the reasons I have been blogging here since Labor Day 2008 is that it is a good discipline. I mostly do it for myself. I want to be right, because I am investing money based on my reading of the markets. Putting one’s thoughts down in writing is a wonderful way to see whether what one thinks actually makes sense. Blogging has helped me focus, and readers have kept me honest. I thank all of those who contribute to this blog with their comments (amazingly, the vast majority of comments contain constructive comments and criticisms). May this be a happy and prosperous year for all.

I would be interested in your thoughts about a worry of mine (which I touched on earlier). I wonder if the investment incentives created by the new tax code might be undercut to some extent by labor shortages. Not all new investments require new jobs, of course, but many do and I wonder where the labor is going to come from.

No one is really sure about the extent to which the decline in the labor force participation rate is the result of structural factors (e.g., a steadily aging workforce as the boomers hit retirement age) and the mass wave of illegal immigration that we've seen in the last 30 years is now being stopped fairly effectively. If the Trump administration succeeds in substantially increasing deportations or even (as some members of the Cabinet want) decreasing levels of legal immigration, the problem of finding people to fill new jobs could be worsened. Certainly, the prospects of increasing legal immigration levels seem dim at the moment.

(One possible offsetting factor is that we may see very substantial increases in Puerto Ricans who move to the mainland US, since the tax incentives for Puerto Rican businesses are greatly diminished in the new tax bill and Puerto Ricans face no barriers to entry to the US.)

Scott, I have read two intervievs from 2016 i 2017 (they are on bloomberg under bx us company fillings) with one of best informed person in US,i.e. Blackstone CEO. Those are everybody december must reads. Takeaways are clear and simple. Acting administration has two tasks. 1 tax reform, deal done. 2 read tape reduction, this takes 2, 3 years. As for cycle duration, 2 or 3 years from now on. As for economy, 1 and 2 should boost it. So these view aligns well with your, Scott.

Miss. Snopes, re "I wonder if the investment incentives created by the new tax code might be undercut to some extent by labor shortages."

If tax reform proves to be effective and pro-growth, it will be because it changes the incentives to work and invest. Those who today are not working or re-investing in their business may change their minds, given the increased after-tax rewards to investing that are now in place. I don't worry about there being a shortage of labor. If businesses have a great growth idea and have trouble finding qualified people, they can always offer to train those people and/or offer higher salaries (justified because their new idea is highly productive).

I've always found it more than coincidental that the big decline in labor force participation began at precisely the time that transfer payments, regulatory burdens, and healthcare mandates began to increase.

Adding thanks for all your insights! Your judgment has been right for a long time. On another note, I was looking for a recent post of yours on consumer debt. I see charts on debt / net worth - that seem innocuous. The WSJ today has debt / disposable income that looks quite ominous. Do you have a view on that?

Happy New Year Scott to you and family !I am a retired Legg Mason FA and I follow your blog regularly.Your last post on 12/31 confused me a bit.In your 11th paragraph discussing the FED you alluded to a possible increase in inflation triggered by a "confidence " increase and a graph of a greater supply of money than demand for it.Can you elaborate some as I thought the opposite would occur ?Thank You Joe McCann harrier1944@gmail.com

Nothing much has changed, but student debt continues to grow. Virtually all of the growth in consumer debt since 2007 has been in the area of student loans, which now total about 30% of consumer credit. As I said last year, student loans look very much like a bubble waiting to pop. They rose over 9% last year, and the default rate continues to be exceedingly high.

Overall, however, consumer finances look to be in pretty good shape. Total household financial obligations (monthly payments for mortgage and consumer debt, plus auto leases, rents and homeowners' insurance, as a % of disposable income, is about the same today (15%) as it was in the early 1980s, and the ratio has dropped from a pre-recession high of 18%. Households' leverage (total liabilities as a % of total assets) has fallen from a little over 20% to about 13% since the peak in early 2009.

Student loans are the big problem, and Congress has yet to address this. But the popping of the student loan bubble is unlikely to be a significant problem for the economy.

Harrier1: I've been talking about how rising confidence is the Fed's worst nightmare for quite a few years. It boils down to this: Quantitative Easing was necessary because the world's demand for money was exceptionally strong in the wake of the Great Recession. Money demand was intense because confidence was very low and risk aversion was very high. The Fed has yet to reverse QE (they are only in the very early stages), but we know that confidence is making a significant comeback and there are signs that the demand for money is weakening (e.g., very slow growth in bank savings deposits). If the Fed doesn't offset the declining demand for money by draining reserves and/or raising short-term interest rates, higher inflation will be the result. There are hints of this happening already: the dollar is relatively weak, gold prices are rising, commodity prices are rising, oil prices are rising, and inflation expectations are rising. It's too early to panic, but nevertheless it is a legitimate concern.

HiI read your missives regularly, and so, thanks for your detailed analysis. You allure to labor force participation, turning higher with the right kind of incentive. Here is a link that shows exactly what you referred to;https://blogs.uoregon.edu/timduyfedwatch/2018/01/07/data-lining-up-for-the-feds-rate-hike-forecast/Labor force participation took off after president Trump's election to office. As you note, this will provide surplus labor, as economy starts to gather steam, keeping wage pressures at bay. DV

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